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Saturday, 27 June 2009

Islamic banks need stress test

Dubai: The US Treasury's stress test of 19 US banks was positioned as a confidence-building - not a solvency-ensuring - measure. Islamic banks need to undertake a customised stress test of their own.

The test should showcase a very different banking model that has so far avoided major bailouts and bankruptcies.

The subprime-induced credit crisis has flushed out the false premise that Islamic banking and fin-ance was disconnected from conventional finance. Islamic finance operates in the same tax, regulatory and legal environment and has the same vulnerabilities of liquidity and confidence crisis as the conventional sector.

Furthermore, as Islamic finance is young, its regulations are fragmented globally. Islamic finance has also been accused of being opaque, which can perhaps also be attributed to the embryonic nature of the industry.

In addition, because of the Sharia prohibitions on riba (interest), gharar (uncertainty) and misyr (speculation), the Islamic bank system has greater exposure to real estate and stock loans, with fewer risk and liquidity management tools and an excessive reliance on commodities (murabaha).

The Islamic finance industry also still has an incomplete information offering for customers, requires more qualified personnel and suffers from the usual complaint about lack of standards.

Should the stress test be extended to Islamic investment banks' wholesale divisions as well? The wholesale divisions of Islamic investment banks seem more vulnerable to the market movements of private equity and real estate.

The seal of approval after a stress test would objectively show that the Islamic finance model works better, or at least differently, than its conventional counterpart in a crisis environment.

While each country's central bank would be the natural lender of last resort for Islamic banks that fail stress tests, the multilateral Saudi Arabia-based Islamic Development Bank could have a role to play here by offering capitalisation funds in return for equity stakes.

The methodology of the stress test will be most important, hence it must be transparent, comprehensive and flush out impaired Islamic assets. This naturally leads one to ask if a "bad Islamic bank" or even asset management company should be set up to buy off-loaded assets as part of a cleansing process, assuming there's no Sharia prohibition issues such as discounting.

- The encouragement of consolidation among smaller banks, presenting an interesting situation of (possibly) a conventional bank buying an Islamic bank and making the acquired entity an independent subsidiary.

- Sale of non-core assets of Islamic banks.

- The need for more and better risk and liquidity management tools, and because of the unique nature of Islamic banks, more frequent (unaudited) reports to the regulators.

- The need for better corporate governance, including independent boards of directors and non-executive audit committees.

- Coordination among the Islamic "lobbying" bodies like the Accounting and Auditing Organisation for Islamic Finance Institutions, Islamic Finance Services Board, International Islamic Finance Market, Islamic International Rating Agency, etc., and the Islamic hubs of Bahrain, Dubai, London and Malaysia.

- A well capitalised global Sharia consulting firm modelled after an international law firm.

In a crisis, there are opportunities to build confidence. The subprime crisis has presented a compelling window of opportunity for Islamic finance to both showcase the merits of asset-based or backed financial intermediation as well as the deployment of savings into real investments without the "financial weapons of mass destruction" of leverage and derivatives.

Islamic finance can make friends and influence people, but it must undertake a confidence-building exercise and cross-sell to non-Islamic users, by way of a customised stress test.

By Rushdi Siddiqui

The writer is global head of Islamic finance at Thomson Reuters. The views expressed here are his and not necessarily those of Thomson Reuters.